Fourth Quarter 2014 Letter to Clients
The past three decades have seen more market extremes than any reasonable person could ever have predicted. And each time these market extremes set in, the conventional wisdom as to where the “smart” money is being invested becomes just as extreme.
In the late 1980s and early ‘90s, Japanese stocks were king. U.S. investors were told that they should have a huge chunk – maybe even the majority – of their stock exposure in Japan, whose economy was thriving while the U.S. was mired in recession.
Then the Japanese stock bubble popped, and U.S. blue chip stocks surged all through the mid ‘90s. “Just buy an S&P index fund and forget it” was the mantra of the day. Before we knew it, though, the dot-com bubble began to inflate in the late ‘90s, and by 2000 we were told it was a new era for tech stocks and “earnings don’t matter anymore.” (Yes, people really said that.)
A few years later that epic bubble burst, and many investors lost everything. But not to worry. “Protect your capital – buy bonds” was the sage advice from 2001-2003. But then bonds stagnated and financial stocks began soaring in the mid 2000s. By 2007 all one had to do to be set for life, we were told, was buy the stocks of big financial services companies associated with the mortgage and housing boom. And then – wait for it – that bubble burst in 2008. At that point, of course, “smart” investors were loading up on gold in advance of the coming hyper-inflation and collapse of the dollar.
And that brings us to today. Oil prices have crashed, and gas is starting to push below $2 a gallon. The dollar (the world’s reserve currency now more than ever) is surging. Deflation, not inflation, is the predominant economic concern – especially in Europe. And U.S. stocks are once again flying high. Meanwhile, anyone who fled to the “safety” of gold a few years ago has seen that investment drop some 40% in value.
So what is the conventional wisdom today? If we could sum it up, it would be this: “Invest in the U.S. and forget the rest.”
It’s easy to build a case for this thinking. Diversified portfolios that have included international stock exposure have trailed the S&P 500 in recent years. The Eurozone countries continue to be mired in economic stagnation. European populations are declining. Why would anyone want to invest there?
If you will notice, though, there is a distinctly backward looking aspect to the day’s conventional wisdom. It is always reactionary in nature. It extrapolates recent events and carries them forward on into the future, indefinitely. Conventional wisdom has a knack for the obvious – for seeing where we’ve been. And it wants to carry that trend forward as if things have permanently changed and we now – finally – understand where the markets are headed.
But markets forces don’t work like that. They are neither static nor predictable. Market forces work like the tectonic plates that float beneath the earth’s surface. They move around in unseen and unknown ways, influencing and shaping things in ways individuals cannot fathom. Occasionally they cause a huge earthquake in the financial landscape, as they did in 2000 and again in 2008. But generally, market forces shape things quietly. This is the invisible hand of the market that Adam Smith famously wrote about more than two centuries ago in his book, “Wealth of Nations.”
Already we are seeing these market forces at work in Europe. Negative interest rates have been introduced by central bankers to keep banks and companies from hoarding cash. France let its so-called “Supertax” expire, which had levied a 75% tax on all incomes over $1 million and spurred a mass exodus of French wealth to other countries. And lower oil prices will benefit consumers there just as they will in the United States. So while the EU economies may seem a mess on the surface, there is really no telling how events in Europe – unpredictable as they may be – will actually influence European stocks as an asset class.
Further to that point, this seems a good place to trot out one of our favorite charts that shows asset class performance by year for the past twenty years, now updated through 2014 (Source: Callan Associates, Inc.):
Yes – we realize this chart is overwhelming and chaotic. That is why we included it: because it perfectly captures the overwhelming and chaotic nature of asset class performance. It is easy to run one’s finger across the top line in recent years and see what the high flyer has been and then make a case for that. But if you’ll notice the big picture – there really is no big picture. Individual asset class performance is wildly unpredictable in the long run.
Stock returns over the long run, however, are not wildly unpredictable. In fact, they have been wildly consistent over long time periods – twenty years and more. Typically, stocks generate returns in the range of 9% to 10% annually. But most investors don’t achieve these returns. Instead, they spend their time trying to catch yesterday’s winning asset class and avoid yesterday’s losing asset class. But they are never positioned for where things are going, because no one knows which asset classes are going to be in or out of favor going forward. No one.
Diversification, then, is the willful act of acknowledging that we don’t have a crystal ball, and will instead strive to the greatest degree possible to capture the overall market’s return by investing in the overall market. In the short term, that means accepting the fact that we will never be completely invested in the day’s hottest asset class. But it also means we won’t have to lose sleep worrying that we are over-concentrated in an asset class that, like the NASDAQ index today, is still trying to get back above water some 15 years later.
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There were two interesting dispatches from the mutual fund industry that popped up during Fourth Quarter 2014. At first glance, the items seem unrelated. Upon further review, however, we aren’t so sure.
The first, and certainly most dramatic, story was the unfolding saga that has shaken the Pacific Investment Management Company – known around the world as PIMCO. Though PIMCO offers both stock and bond mutual funds, its entire reputation is based upon its prowess as a bond manager. And that prowess was vested in its co-founder and resident bond maven, Bill Gross.
Prior to the financial crisis of 2008, Mr. Gross deftly guided PIMCO’s bond funds – most notably its flagship Total Return fund – through a variety of interest rate environments, always somehow emerging in the top of his peer group. The fund beat 96% of its peers over a 15-year time period that ran from the early 1990s to the late 2000s.
But Mr. Gross’s interest rate bets went sideways beginning in 2008, and his once-uncanny ability to divine the Federal Reserve’s future interest rate policy seemed to fade away. The PIMCO Total Return Fund he managed began to underperform that benchmark and its peer group. Assets began to flow out of PIMCO, and Mr. Gross – the company’s co-founder – was forced out in late 2014. When that happened, the floodgates opened and investors made a bee-line for the exits. By the end of last year investors had pulled more than $160 billion dollars out of the company’s funds.
Contrast this, then, with the second story from the fund industry that emerged in Fourth Quarter – the record setting inflows that fund giant Vanguard saw flow in during 2014. Here is an excerpt from a January 4, 2015 article in the Wall Street Journal highlighting the news:
Investors gave stock pickers a resounding vote of no confidence in 2014, pouring $216 billion—a record inflow for any mutual-fund firm—into Vanguard Group, the biggest provider of index-tracking products, according to preliminary figures from the mutual-fund group.
Taken together, we have a paragon of active management, PIMCO, losing $160 billion in assets, while a paragon of passive management, Vanguard sees $216 billion flow in. All in the same year.
It appears that retail investors, after all these years, may finally be getting the memo about market-based investing!